Student Debt Policy Proposal #1: Eliminate or substantially reduce first-year student debt

The elimination of student loans during the first year of college would lower total student debt incurred by most borrowers and provide the largest benefits to people most likely to default.

Potential Policy Changes:  The proposals outlined here involve restrictions on student debt for first-year students, increased financial assistance for first-year students, and new programs to expand access to higher education prior to college.

Specific Proposed Policy Changes:

  • Design and provide funding and incentives for creation of financial assistance packages leading to a debt-free or tuition-free first year at both community colleges and four-year institutions.
  • Eliminate federal student loans until students have 9 credit hours of college credit from AP courses, community colleges or accredited on-line programs.
  • Provide federal, state, and private funds for programs that increase college-level work prior to college.
  • Increased incentives for quick transfers from community colleges to four-year institutions.

Comments:

  • Students who take out loans and do not complete college are around 3 times more likely to default on their loan than student borrowers who get a degree.   The reduction of first-year debt will reduce the debt burdens of people who leave school early and are most likely to experience payment problems.
  • The stipulation that people complete some college level courses prior to full-time college will reduce initial access to higher education by low-income and minority students.  However, these groups with higher student debt burdens would gain the most reduction of first-year debt.
  • The stipulation for some college level experience prior to full-time college would better prepare people for college and would reduce dropout rates.
  • The elimination or reduction in debt among people who leave college after a year or two could facilitate reentry to college after people get some job experience.
  • Low-income and minority students also stand to benefit the most from new programs that increase access to and use of higher education courses prior to full-time college.  For some students, access to a community college or high-quality on-line course would be preferable to access to an AP course with a high fail rate.
  • Universities would be encouraged to increase off-semester admissions to facilitate the admission of more students after a single semester at a community college.
  • The proposed increase in financial assistance at both four-year and two-year institutions will allow more qualified students to choose a four-year alternative.  By contrast, the Biden Administration free-community college proposal would encourage some qualified applicants to delay or forego four-year options.
  • Private schools and historically black colleges could also benefit from changes in financial assistance packages depending in part on the incentives tied to use of federal funds.
  • The changes in financial assistance programs could differ across institutions depending on the level of tuition and the level of state or private support.

Concluding Remarks:  Many people are unprepared for full time college and the burdens of student debt immediately after graduating college.   The proposals outlined here would help many young adults become better prepared for higher education before taking on any debt. 

Financial Tip #9: Payoff the entire mortgage prior to retirement

Avoid taking mortgage debt into retirement to substantially reduce the likelihood of outliving your retirement savings.

Tip #9: People with mortgage debt in retirement must often take large taxable distributions from their 401(k) plan regardless of the level of the stock market.  The elimination of all debt prior to retirement substantially reduces the likelihood a person will outlive their retirement savings.

General Discussion:  Many financial advisors believe it is appropriate for their clients to keep some debt in retirement.   They will advise their clients to take out a 30-year loan instead of a 15-year loan to increase contributions to a 401(k) plan and to take full advantage of the deductibility of mortgage interest. They also argue that people nearing retirement should make additional catch-up contributions to their 401(k) plan instead of increasing payments on their mortgage.

The decision to keep debt in retirement is a recipe for financial disaster, especially if the household is reliant on fully taxed distributions from a 401(k) plan and partially taxed Social Security benefits.  

Issue One: The person with debt will more rapidly deplete their 401(k) plan and will pay higher taxes in retirement.

Discussion:  A person taking out a 30-year $500,000 mortgage, 15 years prior to retirement has annual mortgage expenses of $26,609.  The person that used a 15-year mortgage enters retirement debt free.  See the example presented in Financial Tip #4 Guidelines for the choice between a 15-year and 30-year mortgage.  

The person with the mortgage debt must either reduce non-mortgage expenditures or distribute additional funds from their retirement account to maintain the same consumption as the person that paid off her entire mortgage prior to retirement. 

Large tax-deductible mortgages reduce payment of federal and state income taxes in working years but increase payment of federal state and income taxes in retirement.

  • Retirees without business expenses generally have lower itemized deductions than people in their prime earnings years, hence, the advantages from itemizing in retirement are often small.
  • An increase in the distribution of 401(k) funds to cover the mortgage is fully taxed as ordinary income. 
  • An increase in 401(k) distributions increases the amount of Social Security subject to income tax as discussed on this page offered by the Social Security Administration.  

Issue Two:  The person without debt is better able to maintain current consumption levels and preserve wealth during market downturns.

Discussion:   Typically, a person attempts to maintain a certain level of consumption perhaps 60 percent of pre-retirement income throughout retirement.  A person with a mortgage or a monthly rental payment is less able to reduce expenditures when the value of stocks in their 401(k) falls because the mortgage payment or the rent are not optional. 

Any reduction in disbursements from 401(K) plans, which are reduced in value due to a collapse in stock prices, would have to occur from a reduction in non-housing consumption.   

The largest financial exposures occur when the market falls by a substantial amount in the early years of retirement when the entire savings from working years is exposed to the market.  The market downturn in stocks in 2008 was somewhat offset by an increase in bond values.   This time around both stocks and traditional bonds appear to be in a bubble.   People may want to consider Series I or inflation bonds as discussed in  financial tip #7.

Still, the best way to prepare for a market downturn is to eliminate all debt prior to retirement. 

Concluding Remarks:  During working years, many households take on a large amount of mortgage debt to reduce current year tax obligations. Failure to eliminate all mortgage debt prior to retirement often leads to rapid depletion of 401(k) assets, higher income tax burdens in retirement and increased exposure to financial volatility.  

Financial Tip #8: Make contributions to a health savings account a high priority

Households with high-deductible health plans (HDHPs) need to contribute to their health savings account (HSA) even if lack of funds and limited income causes them to decrease savings for other goals.

Tip #8:  The growth of high-deductible health plans (HDHPs) has increased financial risk and created an incentive for many people to reduce expenditures on essential health services.   People with high-deductible health plans need to contribute to a health savings account (HSA) to offset these risks.  When funds and income are limited, the increase saving for health care will reduce savings in retirement accounts and general liquidity.

Background on Health Savings Accounts:  

  • An HSA is a tax-preferred saving vehicle for people who enroll in an HDHP.   The primary advantage of an HDHP is reduced premiums for the employer and the insured person.   The primary disadvantage is the insured must pay a large share of health expenses.
  • The minimum deductible on a HDHP in 2022 is $1,400 for individual coverage and $2,800 for family coverage.  The maximum allowable out-of-pocket limits in 2022 are $7,050 and $14,100.   It is permissible for the HDHP deductible to be as high as the out-of-pocket limit.   A typical HDHP policy requires the insured person pay a share of all health care expenses after the deductible is met and until the out-of-pocket limit is reached.   
  • HSAs, created as part of the Medicare, Prescription Drug Improvement Act of 2003 are now a major insurance option.   An HDHP is the only plan offered by around 40 percent of employers and is sometimes the most affordable option through employers or on state exchanges.
  • People with high-deductible health insurance coverage are often exposed to large medical bills, take on high levels of medical debt, and often choose to forego necessary medical treatments. The health consequences can be especially severe for people who forego prescription drugs for chronic conditions.  
  • People can reduce the adverse health and financial impacts associate with HDHPs by contributing to an HSA. However, this study by JAMA reveals that one in three people with an HDHP do not have an HSA and that 55 percent of people with HSAs failed to contribute to their account.  An article by SHRM cites work by EBRI which found more than half of people initiating contributions to HSAs do so by reducing contributions to 401(k) plans.
  • The IRS caps the amount of funds a person can contribute to a health savings account.  In 2022 the caps on health savings account contributions are $3,650 for self-only plans and $7,300 for family plans.
  • Contributions to HSAs result in significant tax advantages.   The contribution to the account is not taxed during the year the contribution is made.   The funds are never taxed if they are used for a qualified medical expense.   Funds used for non-medical purposes prior to age 65 are subject to a 10 percent penalty.   There is no tax penalty after age 65.  
  • After age 65, funds disbursed from a HSA are fully taxed but are not subject to penalty.  Funds placed in a traditional 401(k) plan are always fully taxed but are not subject to a penalty after age 59 ½.  Fund placed in a Roth account and investment returns from funds in a Roth are completely untaxed after age 59 ½.  In addition, withdrawals of contribution to a Roth are completely untaxed at any time.

Allocation of Resources between HSAs and other saving vehicles:

People with limited income and high debt have a difficult choice between saving for health-related expenses through a health savings account or saving for other priorities.  There is no one-size fit all approach to the appropriate savings strategy.  

  • Finance Tip #2, concluded that it was okay for a person entering the workforce with high student debt to forego contributions to a 401(K) plan to prepare for emergencies, maintain a solid credit rating and rapidly reduce their student debt. An HSA reduces taxes and allows for the use of funds for medical expenses.  Young adults who have high debt and are dependent on a HDHP should likely contribute to an HSA instead of a 401(k) fund.
  • People with access to a 401(k) plan that does not match employee contributions are likely better off with a combination of a Roth IRA (see finance tip #3) and an HSA.   The HSA gives some tax relief in the year of the contribution while the Roth IRA provides substantial tax savings during retirement. 
  • Workers at a firm that matches employee contributions to a 401(k) plan should maximize receipt of the employer match, as discussed in finance tip #5 and then contribute additional funds to a mix of a Roth IRA and an HSA.
  • The choice between contributing the last dollar to a Roth or the last dollar to an HSA is affected by several factors.    
  • The HSA is the only preferential savings plan that I am aware of that allows for a tax-free contribution and distribution. HSA distributions for qualified medical expenses are never taxed.  The Roth contribution is fully taxed but all distributions after age 59 ½ are tax free and the distribution from the Roth does not increase tax incurred on Social Security benefits.  Workers nearing age 59 ½ will often prioritize Roth contributions because the tax-free distributions could be used for any purpose. 
  • HSA funds can be used to fund retirement after age 65, however, funds not used for medical expenses are fully taxed.  It makes sense to spend HSA funds for health care and retirement funds for general consumption.

Concluding Remarks:  The process of saving for retirement is complicated.  Simply plowing everything into a 401(k) is not an optimal strategy.   As noted in Financial Tip 2 people drowning in debt should even forego matching contributions into a 401(k) plan until they can bring their debt down to a manageable level.  

The growth of HDHPs complicates the savings process.  The increased likelihood of incurring high health care expenses increases the need for an emergency fund. A health savings account, like a 401(k) contribution, provides both immediate tax savings and funds for medical emergency.   The analysis presented here and in previous supports the need for investors to use diverse savings vehicles.

Financial Tip #7: Invest in Series I Savings Bonds whenever possible

Middle income households should purchase some Series I Bonds from the Treasury annually.

Tip #7: Series I Savings Bonds should be included in every investor’s portfolio.  This asset purchased directly from the U.S. Treasury without fees is an effective hedge against inflation and higher interest rates.

Characteristics and rules governing Series I bonds:   The Series I bond, an accrual bond issued by the U.S. Treasury tied to inflation, is described here.  

Key Features of Series I Bonds:

  • Backed by the full faith of the U.S. Treasury
  • Cannot be redeemed until one year after issue.
  • Redemptions prior to five years from issue date forfeiture of one quarter of interest.
  • The composite interest rate changes every six months,
  • The interest rate is based on two components – a fixed rate and the inflation rate.   
  • The composite rate is guaranteed to not fall below zero.
  • The interest is taxed when the bond is redeemed.
  • Bond matures and stops paying interest after 30 years.
  • The Treasury limits annual purchases of the bonds to $15,000 per person with a limit of $10,000 on electronic purchases and $5,000 on paper purchases.  The paper Series I bonds can only be purchased through refunds from the IRS.

Reasons for Purchasing Series I Bonds:

  • Series I Bonds, unlike traditional bonds and bond ETFs, do not fall in value.
  • In the current low-interest rate high valuation environment, traditional bonds and stock prices are almost certain to decline in value.  
  • A retired person with I-Bonds outside of a 401(k) plan can respond to a market downturn by using proceeds from the redemption of I-bonds to fund current consumption rather than disburse funds from a 401(k) plan, which could be temporarily down in value.
  • The Series I Bond is a riskless asset.  Investors with this asset can reduce holdings of traditional bonds and cash and increase investments in equities.

Difference Between Series I Bonds and TIPS:

Treasury Inflation Protection Securities (TIPS also allow investors to protect returns when inflation and interest rates rise.

Key differences between TIPS and a Series I bond as explained here:

  • The TIPS value can fall in an era of deflation.  The Series I bond never falls in value.
  • The tax on interest from TIPS is paid annually and not deferred to redemption
  • TIPS bonds can be sold without forfeiture of any interest at any time.  The redemption of a Series I bond is not allowed until after a year from the purchase date and sales prior to five years from the purchase date involve a forfeiture of a 3 months of interest.  
  • All TIPS can be counted as a liquid asset.   Only Series I older than 5 years from issue should be considered liquid.
  • Up to $5.0 million in TIPS can be purchased in a single auction.  The annual limit on the purchase of Series I Bonds is $15,000.

Thoughts on Series I interest rates:

  • The current fixed interest rate on a Series I Bond is 0 percent.  The current composite fixed + inflation component on bonds purchased prior to May 2022 is 7.12%.  A delay in the purchase of a Series I bond until the second half of the year could result in a permanently higher fixed rate.  However, investors would lose an annualized return of 7.12% accruing in May. 
  • Bonds purchased years ago in a high interest rate environment have a higher current composite rate because the fixed component is higher.  People are currently aware of I-Bonds because of the elevated inflation rate.  The purchase of I-bonds also makes sense when inflation is low and interest rates are high because the investor will obtain both a higher fixed rate and increases in interest when inflation returns.

Concluding Thoughts:  Investors should purchase a Series I bond every year.  Investors who maximize receipt of the employer matching contributions to a 401(k) plan can then divert additional investments to a Roth IRA or a Series I Bond.  People without a 401(k) plan that allows matching contributions should contribute to a Roth, invest Roth contributions in equities, and divert some funds to the purchase of Series I bonds.

Excel Hint #4: Calculating the future value of a mortgage

A key advantage of choosing a 15-year mortgage over a 30-year mortgage is the more rapid decrease in the mortgage balance and increase in house equity. This post discusses the use of Excel to calculate the future value of different mortgages.

Situation:   A person is considering two options for a $500,000 loan.   The first option is a 30-year term at an interest rate of 3.4%.   The second option is a 15-year term at an interest rate at 2.9%.  

  • How can Excel be used to calculate the mortgage balance at 7 years for the two options?  
  • What are the mortgage balances for the two options after seven years?

The Calculation:  The future value of the mortgages above are calculated in Excel with a two-step procedure. 

Step One

Calculate monthly payment from the PMT function.

The arguments of the PMT function are – the monthly interest rate, the maturity of the loan in months, and the initial loan balance.

  • The 30-year monthly payment is PMT(0.034/12,360,500,000) or $2,217.41.
  • The 15-year monthly payment is PMT(0.029/12,180,500,000) or $3,428.91.

These monthly payment values are input for the second step.

Step Two:  

Calculate the outstanding loan balance from the FV function.

The arguments of the FV function are — the monthly interest rate, the number of months the mortgage is held, the monthly mortgage payment, and the initial value of the mortgage.

  • The outstanding mortgage balance at 7 years for the 30-year loan is FV(0.034/12,84,2217.41,500,000) or $424,180.
  • The outstanding mortgage balance at 7 years for the 15-year mortgage is FV(0.029/12,84,3428.91,500000) or $293,466.

Concluding thoughts:  The more rapid build-up of equity from the use of a 15-year mortgage can allow a person to sell a home and pay off the mortgage even if housing prices fall.  The calculations presented here were used in finance tip #4, a discussion of the advantages and disadvantages of 15-year and 30-year FRM.   

Financial Tip #4: Guidelines for the choice between a 15-year and 30-year mortgage

People with substantial liquidity and secure income should choose a 15-year mortgage over a 30-year mortgage.

Tip #4: The selection of a 15-year mortgage reduces lifetime interest payments, leads to a rapid increase in house equity, and reduces the likelihood a person retires with debt. However, many homebuyers cannot qualify for or afford a 15-year loan. 

A Numerical Example

We compare outcomes from a $180,000 15-year and 30-year fixed rate mortgage.  The analysis assumes interest rates of 2.9% for the 15-year loan and 3.4% for the 30-year loan, a typical spread for the two maturities.

  • The monthly interest payments are $1,234 for the 15-year loan and $798 for the 30-year loan.
  • The total interest payments over the life of the loan are $42,193 for the 15-year loan and $107,376 for the 30-year loan.  
  • The total lifetime loan payments are $222,120 for the 15-year loan and $287,280 for the 30-year loan.
  • The remaining mortgage balances after 15 years are $0 for the 15-year loan and $112,435 for the 30-year loan.

Problems with the use of a 15-year mortgage:

  • Many potential home buyers cannot qualify for a 15-year mortgage. Whether an applicant can qualify for a 15-year mortgage depends on—household income, the size of the mortgage and magnitude of other debts.  Lenders restrict monthly mortgage payments to around 30 percent of income and total monthly loan payments to around 40 percent of income.  The applicant for a $180,000 mortgage considered above would require an annual salary of $49,360 for a 15-year loan and $31,920 for a 30-year loan, based solely on the limit on permissible mortgage debt. 
  • A household with a secure job and large levels of liquid assets is better positioned to take out a 15-year mortgage than a household with a less secure position and a lower level of liquid assets.  The choice of a 15-year mortgage necessitates more funds for an emergency; however, financial experts are largely silent about the amount of additional liquidity that is needed for recipients of a shorter-term loan.  One potential rule of thumb is for borrowers to keep liquid funds equal to 12 monthly mortgage payments.  Note as discussed in Finance Tip 3, contributions to Roth IRAs can be withdrawn at any time without penalty or tax, hence, owners of Roth IRAs may require less cash savings for emergencies than owners of traditional retirement plans.
  • The higher monthly payment associated with the use of a 15-year mortgage may cause the household to reduce contributions to retirement plans to meet daily living expenses.   However, retirement plan contributions could increase once the mortgage is paid off.  A decrease in contributions to traditional retirement plans can increase federal and state income taxes.
  • The use of a 15-year mortgage could reduce the amount of interest that is deducted from income against both federal and state income tax.  The potential impact of the choice of a mortgage on taxes is small in the early years of the mortgage when most of the monthly payment is interest and high in the final years when the mortgage payment goes mostly toward payment of principal.
  • Substantial home equity can be seized by creditors even in a bankruptcy situation in most states. People with aggressive creditors or people facing litigation may want to maintain a large mortgage to repel claims by creditors.

Advantages of 15-year mortgages

  • The use of a 15-year mortgage allows for a rapid accumulation of housing equity, which can be used as a down payment for a future house purchase. The higher accumulation of equity from the use of a 15-year mortgage increases the likelihood that a person will be able to pay off the old mortgage and put a large down payment on a new home even if house prices fall in value.
  • Consider the outstanding mortgage balance on a $500,000 mortgage at a 30-year term at 3.4% or a 15-year term at 2.9%.   The outstanding mortgage balances after 7 years are $424,180 for the 30-year term and $293,466 for the 15-year term.  The outstanding mortgage balances after 3 years are $469,697 for the 30-year loan and $415,548 for the 15-year loan.   The use of a 15-year loan can lead to substantial build up in house equity even over short holding periods when housing prices don’t rise.
  • A decrease in resources spent over a lifetime on home purchases increases resources available for other goals.  Monthly mortgage payments are higher during the first 15-years of a 15-year loan but are non-existent after 15 years.  The ability to end mortgage payments after 15 years is extremely important for a person nearing retirement, especially if this person is reliant on a traditional retirement plan, with fully taxed disbursements.  The elimination of all mortgage debt prior to retirement allows retired workers to reduce 401(k) distributions, avoid tax and avoid rapid depletion of their 401(k) plans in years where the market is down. 

Concluding Remarks:

Many real estate brokers favor the use of 30-year mortgages because it allows the buyer to entertain the possibility of a more expensive home.  Many financial advisors favor the use of a 30-year mortgage because it allows the household to make larger contributions to retirement plans and brokerage accounts.  These advisors often overstate the potential tax savings from the use of 30-year mortgages and often fail to discuss the extreme importance of total elimination of the mortgage prior to retirement.

The use of a shorter term mortgage allows a home buyer to accumulate equity quickly. Potential homebuyers should be able to calculate the impact of their mortgage choice on their future mortgage balance and future equity. Go to Excel Hint 4 for a discussion on how to calculate the future outstanding mortgage balance.

The use of a 15-year mortgage requires the homeowner to have a larger liquidity cushion to avoid payment problems from unforeseen events.  Many people with low levels of liquid assets at the time of the house purchase and mortgage origination should refinance to a 15-year mortgage after increasing their annual income and their liquid assets.